The Amateur Investor's Guide To Analyzing Corporate Efficiency

Professional analysts have many advantages, because they have the ability to call company officers directly, take tours and go to analyst meetings. Retail investors who are attempting to analyze a company on their own are fairly limited by way of access and information. However, there are a number of ways that the amateur investors can measure how well management is performing.

Ratio AnalysisReturn on EquityOne of the first and most common ratios used to analyze a company's management is the return on equity (ROE). Investors or shareholders are the company owners, and through their representatives on the board of directors, a company president or chief executive officer is selected. As a partial business owner, you will want to know how effective your manager is with your money and you can do so by comparing the net income of the business to the number of shareholders.

Net Income/ShareholdersBy dividing net income by the number of shareholders, a ratio or percentage will occur. The ratio by itself doesn't really tell you much, but instead it will give you something to compare with other investment alternatives. For instance, comparing a company's ROE to other firms within its sector is a good approach to measuring the company's competitiveness.

Return on AssetsThe next ratio of importance is return on assets (ROA) which attempts to measure management's effectiveness at using the company's assets. ROE measures how well management is employing your money, whereas ROA shows how well management is employing the company's resources. This formula is also a simple calculation.

Net Income/Total AssetsThis ratio is best interpreted in the context of the stock's industry group, because it's an "apples-to-apples" comparison. Some industry groups can be capital-intensive and require a lot of manufacturing and/or production equipment. Therefore, a comparison of the S&P 500 wouldn't necessarily be helpful. Assets aren't just equipment and land, but also debt and equity. If a problem arises, it's likely that money will have to be spent to fix it. Dumping money into a problem doesn't fix it - good management will make sure the money is used wisely and the ROA can tell investors how management is doing when problems arise. (For a more indepth look, check out Understanding The Subtleties Of ROA Vs ROE.)

Return on Invested CapitalThe return on invested capital (ROIC) ratio attempts to measure management's ability to allocate the company's capital into profitable investments that produce returns. Capital is long-term debt and shareholder equity, including preferred shareholders. However, since shareholders may be entitled to dividends and dividends reduce net income, the ratio excludes dividends.

Net Income – Dividends/Total CapitalThe ratio is commonly used to measure management's effectiveness over time, and investors should look for an ROIC of 10% or higher over 10 years. This will give investors an instant track record for management. (Learn more in Spot Quality With ROIC.)

Growth RatesThere are two common growth rates for sales and earnings. These two each tell a story of their own, and another story when combined. Obviously, higher sales and higher earnings are a good sign for the company. When looking at growth companies in the small and mid-cap range, you should expect to see the growth rates at 20% or higher. Large-cap companies will find it difficult to reach this level, because they are so big. Therefore, you will need to lower the standard depending on the size.

While seeing sales rise is an excellent sign for a corporation, if management can't turn rising sales into rising earnings, it may not matter how great sales look. This is why we also want to see that the earnings growth rate is higher than the sales growth rate. (For more, see Steady Growth Stocks Win The Race.)

Insider OwnershipInvestors can determine the motivation of management to succeed by looking at the number of shares they own. The number of shares outstanding is the number of shares the company has issued to the public. The float is the number of shares that can be traded on the stock exchanges. The difference between the number of outstanding shares and the number of shares that make up the float is how many shares the insiders own. In other words, their compensation is highly tied to stock performance, motivating them to appreciate the stock prices.

Since insiders do receive a lot of compensation through company stock options, it may be beneficial to observe whether or not insiders are buying or selling. The problem comes because insiders sell for various reasons, like buying a home, purchasing a new car or sending a child to college. The selling of shares happens all the time, so insider selling isn't as great an indicator as you might suppose. However, insider buying is, because this means the insiders are actually forking over their own hard-earned money to pick up shares. If the company is rewarding them with shares on a consistent basis, there is little need to purchase shares with their own money. If they are purchasing shares, there is probably a good reason for it. At market bottoms, it's common to see a lot of insider buying but they can some times be premature. Another industry group caveat is that small regional banks commonly see a lot of insider buying just for the sake of owning the shares. (For more, read When Insiders Buy, Should Investors Join Them?)

Listening to Conference CallsInvestors will need to take some time to listen to previous conference calls and find out if there are any changes in the verbiage. Look for hesitancy in areas where confidence exuded before. However, the best indicator is to simply watch what the stock does after an earnings announcement. Often, an announcement or call will sound great, but the market will sell the stock down. Don't try to out-think the market - it's always right. If the market doesn't like the conference call and you don't know why, it is very dangerous to hang on to your position out of pride. Inserting a stop-loss order or hedging the position would be wise. (Learn more in Conference Calls: Press 1 For Investment Insight.)

ConclusionIt's helpful to know that your company's officers are highly motivated to increase the stock price because they are compensated in a similar fashion to you by the appreciation of share value. Finally, listening to the conference calls and monitoring market movements after announcements are a good way to see if the company is still having success. Make the measurement of management moxie part of your successful investing plan. (To learn more, check out our Earnings Quality Tutorial.)